Understanding 'Skin in the Game' & the pass-through model of risk

Taleb's new book, 'Skin in the game', comes with twists and turns that we missed in his earlier threesome, 'Fooled by randomness', Black Swan' & 'Anti-Fragile'; more twists than turns may be, but one would be intrigued to get to the very end as many of the life's mysteries unfurl with some logical rigor or without.

His 2013 paper, which I attach on the same subject was more focused and with mathematical rigor, which is somewhat dispersed in his current narrative in the larger context where he is trying to examine almost all of life's challenges and the world's with the lens of who bears the risk and who is the free-rider.

Most are free riders who shift the risk to the risk takers who bear the cost, without skin in the game they benefit from free-riding. Take the advisers or the consultants who would not be executing the very advice they are giving at a price, they are the best examples of moral hazard as they remain insulated to the loss function when the projects do not fructify to give the desired outcome. Or take the central government bureaucrats who on behalf of the government could be the advisers to public policy and they have no skin in the game as execution is hardly left to them and the end results unravel far into the future. It could be also true with politicians without skin in the game as well, who are elected for a limited term whereas consequences of their actions are only visible far out into the future.

This is also the reason when sometimes politicians demonstrate skin in the game on the contrary and they derive their credibility in the process; they are best risk takers when they enact policies which have immediate consequences like demonetization in India or raising tariffs in U.S. or making nuclear tests in North Korea, whatever the reasons they take responsibility for their actions.

The investment bankers have far less skin in the game, they run a pass-through model of risk. If there is an upside they gain from it, while they pass-through the loss appropriately, as well.

The municipal corporations on the other hand or the smaller Cantons called Gemeinde in Switzerland have skin in the game as they take responsibility for the actions and the consequences. Small self-government centers have far higher skin in the game.

Those who have the most skin in the game are the entrepreneurs, the startup architects or the independent designers, writers or craftsman. Some of them Taleb describes as having 'Soul in the game'. The best example of this would be Jesus, who sacrificed his life for his beliefs or Socrates, who had his family to protect whereas he never compromised on his principles and his ethics. Every Roman emperor had to be at the battle field along with his army and had skin in the game, literally, as their skin could be burnt every time they went out to war; there had to be some bigger dis-incentive to war to prevent them from going to it.

Taleb reaches out to some deeper questions as well, like what could be the best way to solve terrorism, by creating larger and bigger dis-incentives to self-sacrifice that many terror-recruits turn up to as it might protect their families from financial ruin; what currently we end up doing is incentivizing their self-sacrifice.

In Chapter 7, Taleb takes a dig at inequality and takes a turn from the usual economists view; his tirade against Piketty is more pronounced here as he unravels a time dimension never explored before. The asymmetry in income from wage or capital is real but the treatment meted out by the Economists have been cocooned in the belief that those in the top 1% remain the same people, they actually do not. Thus the dynamic nature of the asymmetry remains out of scope of the argumentative economists.

I like the prescription that Taleb proposes to dis-incentivize the system that would otherwise make allowance for people to continuously stay at the top of the table of earnings; if competition is allowed there will be perfect reason for the most able to stay at the top and not due to their ability to lock privileges.

But I was pleasantly surprised with his treatise on Ergodicity in Chapter 19, where he demonstrates succinctly how the ruin of one in a casino does not affect the ruin of others or put in the context of the financial markets, no individual can get the same returns as the market unless he has infinite pockets or to put it differently his returns will be divorced from the market returns unless he decides to reduce his exposure by specific interventions. Buffett on the contrary demonstrates his skin in the game by announcing every time that he does not intend to sell any of his holdings and advised all first time buyers not to buy his Class A shares.

The book leaves many questions, the central theme around minority having all decision making authority over the majority is not a striking revelation though; the world around actually believes that it is governed by the majority ruling through their representatives.

'Skin in the game' would leave one depressed that many of the established beliefs are based on a view that assumes that a large number of low risk events, all mutually exclusive, does not add up; it actually does. But those having no skin in the game are the biggest beneficiaries leaving all the risks to the others who must sacrifice to bear the costs.

The tone of the language in the book is a cause for concern, here Taleb is more like Richard Dawkins, whom he has criticized throughout the book; having a different view does not make one so authoritatively audacious, this is where Taleb needs to improve, having feeling for others is also part of 'Soul in the game'.